Activist Investing

So what happens when the board of directors does not look out for the Shareholder's best interests? Stock prices are suppressed (aka they are lower than they should be). For example, if the board of directors pays the CEO $100M a year, when he is only worth $5M per year- the company is worth $95M dollars less than it would be if the directors paid the CEO an appropriate salary. (Note: I only use the salary of a CEO as an example because it is relatively straight forward. In world of corporate governance, overpaying the CEO is a minor offense- the board of directors is capable of squandering much-much more than $95M).

This loss of $95M is reflected in the stock price. So instead of each share of stock being worth, say, $10 (as it would be if the CEO received a salary of $5M), the stock is only worth $8.

In a perfect world, this would not be a huge problem. We could simply recognize the board's error, vote out the old board, and replace them with a new board that would rectify the problem.

Now, here is the problem (well there are actually lots of problems- but here is the meta-problem); It is really expensive to vote out the incumbent board. There are lots of reasons for this (many of them having to do with corporate governance- which I will be the topic of many subsequent posts). Because it is so expensive- it is only worth attempting to replace the incumbent board if you own a significant portion of stock.

For example, it can cost tens of millions of dollars to even attempt to replace a board of directors. If you only own $1,000 shares of stock- each worth $8 ($8,000 in total) then you are obviously not going invest millions of dollars. Even if you are successful at ousting the incumbent board, and you raise stock prices to $10 a share- you have only earned $2,000.

Therefore, we generally must rely institutions that have access to large amounts of capital to discipline boards that do not adhere to shareholder interest (at least for the time being). (Note: hostile takeovers can serve a similar function- more on hostile takeovers in another post).

These institutions often take the form of hedge funds- which we deem activist hedge funds (or activist invstors).

Their investment strategy is to buy a large stake in a company with a suppressed stock price due to the waste of the board of directors, then replace the board with their own (alternatively they can discipline the existing board). In turn, the company's price rises (thanks to the reduction of wasteful activities- like overpaying the CEO) to reach its full potential, and the activist hedge fund realizes a profit.